Unveiling the Vital Role of Credit in the Financial System. Why Banks Exist?

Credit is the foundation upon which finance is built. Without credit, the financial system would crumble. It is a critical part of the economy because it is the largest and much more volatile part. Banks exist for a variety of reasons beyond just issuing credit, although that is indeed one of their fundamental roles. Here are some key reasons why banks exist:

1. Issuing Credit: One of the primary functions of banks is to provide credit to individuals, businesses, and governments. Banks accept deposits from customers and use those funds to extend loans and issue credit, facilitating economic activities such as business expansions, home purchases, and investments.
2. Depository Services: Banks offer a safe and secure place for individuals and businesses to deposit their money. These deposits can be easily accessed and used for transactions, making banking services essential for day-to-day financial operations.
3. Payments and Settlements: Banks play a crucial role in facilitating payments and settlements between different parties. They provide various payment services, such as issuing checks, facilitating electronic funds transfers, and offering debit and credit card services. Banks ensure that funds move securely and efficiently between individuals, businesses, and institutions.
4. Asset Management: Banks offer a range of asset management services, including investment advice, wealth management, and portfolio management. They assist individuals and organizations in effectively managing and growing their financial assets through various investment products and strategies.
5. Financial Intermediation: Banks act as intermediaries between savers and borrowers. They collect deposits from individuals and businesses seeking to save or invest their money and channel those funds to borrowers who need capital for various purposes. This intermediation process helps allocate capital efficiently and promotes economic growth.
6. Risk Management: Banks provide various risk management services to individuals and businesses. They offer insurance products, derivatives, hedging instruments, and other financial tools to help manage risks associated with currency fluctuations, interest rate changes, commodity price volatility, and other market uncertainties.

Regarding central banks, their role is slightly different. Central banks are typically government institutions that oversee monetary policy and serve as the lender of last resort. Some key functions of central banks include:

1. Monetary Policy: Central banks formulate and implement monetary policies to regulate the money supply, interest rates, and credit availability in an economy. They aim to maintain price stability, manage inflation, and support sustainable economic growth.
2. Financial Stability: Central banks are responsible for promoting and maintaining stability in the financial system. They monitor and regulate commercial banks, set capital requirements, conduct stress tests, and intervene if necessary to prevent systemic risks and bank failures.
3. Lender of Last Resort: Central banks act as the lender of last resort, providing liquidity support to banks and financial institutions facing temporary funding shortages. By offering emergency loans and ensuring the stability of the banking system, central banks help prevent widespread financial crises.
4. Currency Issuance: Central banks are typically responsible for issuing and managing the national currency. They ensure the availability of physical cash, oversee the operation of payment systems, and maintain the integrity of the currency.

Overall, credit and lending are the core functions that define the role of banks in the economy. They enable the efficient allocation of funds, facilitate economic growth, and provide essential financial services to individuals and businesses.

While governments do want banks to issue credit and promote economic growth, it is important to note that banks operate within a regulatory framework to ensure stability, consumer protection, and prudent lending practices. The balance between credit expansion and risk management is essential to maintain a healthy financial system. The commonality between banks lies in their core function of credit or lending. Credit is the provision of funds or financial resources to borrowers with the expectation that the borrowed amount will be paid back in the future, usually with interest. Banks serve as intermediaries between those who have excess funds (savers or depositors) and those who need funds (borrowers).

Here's how credit and lending are common to banks:

1. Deposits and Loans: Banks accept deposits from individuals, businesses, and other entities. These deposits form the basis of the funds that banks lend out to borrowers. Banks leverage the deposits they receive to extend loans and provide credit to borrowers for various purposes such as starting a business, buying a home, or financing projects.
2. Interest Income: Banks earn income by charging interest on the loans they provide. The interest rate is the cost of borrowing for the borrower and represents the return earned by the bank for the risk it assumes by lending money. Interest income generated from loans is a significant revenue stream for banks.
3. Credit Evaluation and Risk Management: Banks assess the creditworthiness of potential borrowers before granting loans. They evaluate factors such as the borrower's income, credit history, collateral, and repayment capacity to determine the risk associated with lending to them. Banks employ risk management practices to minimize the potential for default and to protect their depositors' funds.
4. Creation of Money Supply: When banks lend money, they effectively create new money in the economy. This is because the loans provided by banks are typically deposited into the borrowers' accounts, which become new deposits. These deposits can then be used for further lending or other economic activities. This process is known as fractional reserve banking and contributes to the expansion of the money supply.
5. Role in Economic Growth: Banks play a crucial role in promoting economic growth by providing credit. Access to credit enables businesses to expand operations, invest in new projects, and create job opportunities. It also allows individuals to make significant purchases, such as buying homes or financing education, which contributes to economic activity and overall prosperity.

While credit and lending are common to all banks, it's important to note that different types of banks may focus on specific areas of lending. For example, commercial banks primarily serve the general public and businesses, offering a wide range of lending services. Investment banks, on the other hand, focus more on providing capital and advisory services for corporations and facilitating complex financial transactions.